Henry Rand Hatfield.

Modern accounting, its principles and some of its problems online

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it seems that any expenses necessarily involved in organiz-
ing a going concern are properly assets of that concern,
as much as are the real estate, the machinery, or the stock
in trade. To the stockholder or proprietor it is part of
the investment from which profit is to come and is hence
capital expenditure. Being necessary to the establish-
ment of such a concern rivals cannot spring up, unless they
too provide capital for such a payment, and actuarially
figured a concern fully established is worth to new oper-
ators a premium equal to the cost of organization. Fur-
thermore, as was most clearly brought out by Justice
North in Abstainers and General Insurance Company
( [1891], 2 Ch. 125) any other treatment of such payments
would have the absurd result, already alluded to, of mak-
ing necessary an initial inroad into capital except where a
company started with a nominal surplus.

The effect is similar whether the payment of organiza-
tion and other similar expenses is charged directly to the
Construction Account or is carried along as an inde-
pendent item. The significant fact is that both in theory
and practice the sums so paid are held to represent assets.
Whether it is better to show them in increased cost of
plant or as an independent item is debatable. German
legislation allows only the former, the idea being that it is
dangerous to allow the appearance of " fictitious " ac-
counts among the assets. It also attempts to discriminate
between the preliminary costs of construction which are
to be charged to the plant, and the costs of organizing the
corporation itself, which are not to be counted as an asset
at all. In order to provide for these latter it is customary


in Germany to issue the original capital at a premium suf-
ficient to cover the preliminary expenses. But in America
the preferred practice seems rather to favor listing Or-
ganization expenses and similar iteme as a separate item,
for attention is thus called to their somewhat intangible
character. This custom also furthers the conservative
practice of annually charging off a considerable portion of
such items, so that in a few years they disappear from the
inventory altogether. But the Interstate Commerce Com-
mission provides in its rules for classification of expendi-
tures for road and equipment that organization expenses
shall be charged to the construction or equipment account.
In the problems thus far discussed the question has
been whether a payment of a definite sum should be con-
sidered the cost of an equivalent asset, or merely the pay-
ment of an expense. Another problem arises in connec-
tion with the purchase of property with stock or bonds
instead of with cash. Here the difficulty turns not on
whether an asset has been acquired, but on the uncertain
value of that which has been given in exchange therefor.
In actual practice it is all too customary to treat the cost
of such property as being equal to the par of the stock
issued therefor. Even accountants of the highest standing
justify such a procedure. Evidently this is but one as-
pect of the much-debated question of stock watering. To
assume that the value of the property acquired equals
the face of the stock issued is to assume that stock never
is, and never can be issued in excess; that there can be no
stock watering. It argues in a vicious circle, for it makes
the value of the property dependent upon the amount of
stock issued, while capital is to the accountant properly
an expression of the value of the net assets owned, a sum
representing the net wealth of the proprietary interests.
If carried to the logical extreme, this principle would re-
quire that where stock is sold at a discount the cash re-


ceived should be treated as equal to the full face value of
the stock, though it is in fact only a fraction of that sum.

It is true that there are difficulties in determining the
real value of the property purchased with stock, and stat-
utes and courts have doubtless been wise in refusing to
interfere with valuations placed on property; but because
the courts cannot detect the error is no excuse for a willful
misstatement of the value of the property acquired. The
Connecticut law of 1903, while recognizing that the valu-
ation of the property is a function of the directors and not
of the courts, sets a high standard in requiring that where
stock is issued for anything except cash the " directors
shall make and sign upon the record book of the corpora-
tion a statement showing particularly of what the prop-
erty received in payment for stock subscriptions consists,
and that it has an actual value equal to the amount for
which it is received." The judgment of the directors is
properly made final, but they are liable for fraud in over-
valuation. Less complete is the provision made in other
statutes that the accounts of the company shall clearly
show that certain property was acquired in exchange for
stock but without implying an equivalence in actual value.
This subject is discussed more fully in Chapter IX.

3. What is the basis of revaluation?

Having accepted the principle that the original valua-
tion of assets should not exceed the cost price, and having
noticed the practical and theoretical difficulty in deter-
mining the exact cost price, there remains the more impor-
tant question as to subsequent revaluations of assets.
Shall they be put down at the original acquisition price
or at some other valuation? If at some other value, shall
it be the current market price, the present value to the
concern, or the price they would bring in liquidation ? The
general principle which, with various* applications, is now
universally accepted, is: The inventory should be on the


basis of the value of the assets to the present holders as a
" going concern." The proper value is that which they
have to the holding concern, and not that which they might
have to other persons, whether these persons are ordinary
customers, or those who might bid in the assets at a liqui-
dation sale. The value is that which they have to the
company as then existing and not to a company in the
hands of a receiver, or one closing up its accounts and
going out of business. It is true that in the case of cor-
poration this represents the interests of the stockholders
rather than those of the creditors. Yet it is little exag-
geration to say that if all assets were listed at the value
which they would realize at forced liquidation, no Balance
Sheet would show solvency. Valuation on such a basis
would, therefore, be absurd, and the general principle
must be adopted that the basis of inventory values is the
present value of the asset to the holders as a " going con-
cern. " To this rule there may be exceptions or modifica-
tions, mostly introduced for the sake of preventing a self-
deceiving exaggeration of values.

This leads to another distinction of great importance,
that between " fixed " and " circulating " assets. It is
impossible to draw a sharp and absolute line between these
two classes, but in general the differentiation is easily
made. By fixed assets are meant those which are bought
for permanent or long-continued use, by circulating assets
those whose use is relatively short or which are purchased
for resale as merchandise. There is coming to be recog-
nized a difference in the basis of valuation of these two
classes of assets, which permits much greater latitude in
regard to fixed assets than is allowed concerning circulat-
ing assets. In general it is considered legitimate to con-
tinue fixed assets at their cost despite a subsequent decline
in their value. But in valuing circulating assets regard
must be had to current values, although "there is some


question as to whether the market value, even of circulat-
ing assets can be accepted where that exceeds the original
cost. 1 Here again the governing principle is that of the
" going concern." A piece of land, for instance, is pur-
chased at a fair price for the purpose of erecting a fac-
tory. Its services are presumably perpetual and undi-
minishing; the value to the company was, in the first in-
stance, represented by its full cost price ; its services, and
hence its value to the going concern, are the same as before.
It is therefore proper to continue in the inventory the cost
price of the land quite irrespective of changes in its market
value whether that be greater or less than the cost. The
market price, evidently, can never be realized so long as
the land is still used as a factory site, the abandonment of
the factory means ordinarily that the enterprise ceases to
be a going concern. To be sure the factory site might con-
ceivably be sold and a less expensive one be bought in its
stead, but this implies recognition of a double set of un-
realized conditions and is too vague for embodiment in
formal accounts. Changes in the market value of an abso-
lutely fixed asset, such as land, railroad bed, or water
rights, may be ignored on the principle that such changes
do not affect the value of the going concern. This is most
clearly seen in the case of land, but it is equally applica-
ble to any form of fixed asset provided, of course, that
allowance is made for its necessary maintenance and re-

A corollary of the foregoing is that mere fluctuations
in value in contradistinctions to permanent change of
value, may be ignored. This is theoretically correct, for
fluctuations so transitory as to be included within the
period during which the company holds the given asset are
analogous to changes in the value of a fixed asset. If raw
material is bought in July and the finished goods are to be

1 See Chapter V.


marketed during the following June, the oscillations of
price within that period need have no effect on the value
of the material in the manufacturer's hands. To take
account of a temporary rise or fall in a December in-
ventory in such a case would perhaps be erroneous; cer-
tainly so if it were known that the normal price would
again appear before the year's end. But in practice the
principle is difficult of application, because of the impos-
sibility of determining which changes in price are mere
temporary fluctuations and which are more permanent
alterations in value. It is, however, of importance in
application to the fluctuation in the market price of invest-
ments, although here, as is shown in the next chapter, con-
servative practice justifies a less logical treatment. .

Another corollary needs mentioning. If changes in the
market value of an unchanging asset need not be reck-
oned the converse is true. Actual changes in the use value
of a fixed asset, a machine for instance, must be reckoned,
even though to the eye the machine remains unchanged.
In technical terms, while fluctuations in fixed assets may
be ignored, depreciation must always be considered. This
is true whether there is actual physical deterioration or,
as in the case of a patent right or a terminable leasehold,
the decline is due to the approach of the time when the
present asset will cease to have value. The three rules cf
appraisal of general application are therefore: (1) The
value to be taken in the inventory is not the liquidation
value, but, that to a going concern; (2) Changes in market
value of fixed assets may be ignored; (3) Depreciation
must always be taken into account.

In all the foregoing discussion it has been assumed that
the purpose of accounting is to present the facts fully and
without reservation ; but argument is sometimes made that
the statement set forth in the Balance Sheet does not even
profess to be true ; indeed, that a variation from the truth,


provided only that it understates the wealth of the con-
cern, is really a merit rather than a fault. This view has
formally been set forth in a recent English case where the
court stated that " The purpose of the Balance Sheet is
primarily to show that the financial position of the com-
pany is at least as good as there stated, not to show that it
is not or may not be better. ' ' 1

This view is frequently supported by theoretical writers
and has the further sanction which comes from the prece-
dent set by conservative corporations in all lands. Thus
it has been argued that an undervaluation improves the
economic position of the corporation, that it prevents the
danger of fictitious dividends, and that " absolute truth
in the Balance Sheet is not only not demanded by law but
is in itself undesirable. ' ' For precedents may be cited the
Bank of England which omits from its statement its land
and building, which are certainly worth many millions;
the practice common among German companies of listing
their real estate and sometimes their other fixed plant at
the nominal sum of one mark; and the tendency among
American railways to mark down the valuation placed on
the road whenever large earnings make that possible.

In so far as the undervaluation of certain assets ic
merely an attempt to secure a more truthful conspectus
of the entire situation, the action may be justified. An
argument that however truthful one's intentions may be,
he is almost sure to overestimate the value of his own pos-
sessions, and therefore after having determined what he
really thinks they are worth, his results will be more accu-
rate if he arbitrarily writes off certain sums, is not without
force. But to state that an absolute understatement is
praiseworthy neglects the fact that fraud may surely be
perpetrated in that manner ; and while the reaction against
overvaluation is but natural and in general healthful, it

> Newton v. Birmingham Small Arms Co. [19061 2 Ch. 378.


seems a mistake to overlook the value of accuracy and to
cease to hold it up as the goal of accounting. Time was,
and that not long since, -when even the Supreme Court of
the United States stated that there is but little danger
that any board of directors will ever understate the value
of the assets, thereby also underestimating the profit, the
temptation being in the opposite direction. 1 But certain
notorious bear operations in the stock exchanges show that
the unforeseen has frequently happened, and the under-
valuation of assets, with its accompanying understatement
of profits and establishment of a secret reserve, if the lesser
of two evils, nevertheless falls far short of the ideal stand-
ard of accounting.


DICKSEE, L. R. Auditing. American edition, edited by R. H.

Montgomery, pp. 160 ff. New York, 1905.
HERE, J. P. The Appreciation of Assets. When is it legitimate?

Journal of Accountancy, III, p. 1.
PIXLEY, F. W. Auditors, their Duties and Responsibilities. I,

Chapter XI. Ninth edition. London, 1906.
REHM, H. Die Bilanzen der Aktiengesellschaften. pp. 693-790.

Munich, 1903.
SIMON, H. V. Die Bilanzen der Aktiengesellschaften. pp. 289-322.

Berlin, 1899.

For arguments in favor of valuing assets at their liquidation
value, see:

ARNOLD, H. L. The Complete Cost-keeper, pp. 358-359. New

York, 1900.
NORRIS, H. M. Machine-tool Depreciation as an Element of

Manufacturing Cost. Engineering Magazine, XVI, pp. 958-


1 Union Pacific R. R. Co. v. U. S. 99 U. S. 402.



IN the light of the norms laid down in the preceding
chapter the problem of the proper valuation of various
kinds of assets may be considered. These may conven-
iently be grouped into certain classes: Land, Buildings,
Machinery, Investments, Mercantile Credits, and Merchan-


What has been previously said in regard to fixed assets
generally, applies preeminently to land where that is held
for the uses of the company. The rule here is that land
for permanent holding may be held at its cost despite a
decline or rise in its market value. Legal authority for
this view is given in Bolton v. Natal Land and Coloniza-
tion Co., Lim. ([1892], 2 Ch. 124) where the court held
not only that a company need not bring into its accounts
the increase or decrease in the value of its lands but that,
at least so far as it affects the showing of profits, it is not
right so to do.

Occasionally, however, a question may arise as to what
is the cost of the land. Difference of opinion arises as to
the treatment of legal fees connected with the examination
and recording of title. Practice seems to favor adding
these to the price paid in determining the cost, but the
high authority of Pixley is against such a practice. The
arguments previously given regarding organization ex-
penses support 'the current practice.

Where a purchase mortgage has been given in partial



payment of land it is sometimes the custom to add inter-
est paid on the mortgage to the value of the land ; but this
is unjustifiable for the interest is not a part of the cost of
acquisition nor does it represent any additional value ac-
quired, and even though it were parallel to an accretion
in value (an assumption far from true), appreciation of a
fixed asset is not to be booked.

Property acquired not for permanent use but for resale
is analogous to merchandise bought by a trader. Where
the land requires improvement, as where a large tract is
purchased to be provided with sewers, streets, gas and
water pipes, sidewalks and other improvements, with the
expectation of subdividing and selling it in small parcels;
it is in almost the same category as raw material bought
by a manufacturer to be used in producing his finished
commodity. In such cases the principles applying to the
valuation of merchandise and of partly finished manufac-
tures respectively are to be applied to the valuation of
the land. The expenditures actually incurred in acquir-
ing the land, including those incident to bringing it into
the desired form for sale, may properly be considered as
entering into the value at any time during the process;
but it is incorrect to add any sum representing an esti-
mated appreciation. By some authorities interest actu-
ally paid on a purchase mortgage during the improve-
ment period may be added to the value of the land, but
interest at a rate which it is estimated would normally
have accrued on a similar sum loaned out, may not be
added. This makes the treatment of interest payments
on land where the land is being worked up into a market-
able commodity similar to that of interest paid during
construction of a railroad. But the better practice is
against such a marking up of the value of land designed
for sale. That there is no absolute criterion universally
adopted is shown by the fact that in Germany the laws


permit interest paid to be added to the value of real estate
held by a company with limited liability (Gesellschaft m.
b. H.) but does not allow this to be done where the owner
is an ordinary corporation. (Aktiengesellschaft.)

While the improvement of a large tract of land is
analogous to the manufacture of commodities, the fact that
the various small parcels of land differ widely in value
makes the estimation of the value of the unsold portion
of a tract of land a little more difficult than the appraisal
of the unsold portion of the stock of identical commodities.
A tract may have been purchased and divided into say one
hundred lots, half of which are sold. The presumption is,
however, not at all that the remaining half represents one
half of the original cost. The proper basis is to appraise
the value of each separate parcel at the market price, and
to assign to it as the inventory value that proportion of
the total cost which its appraised value bears to the total
appraisal. Thus if a block of land is bought and divided
into one hundred lots at a cost including improvements of
$150,000, the sum of the appraised value of the one hun-
dred lots after improvements have been completed may
be $200,000, the appraised value of lot A because of its
superior location, being $4,000; but the value to be as-
signed to A in the inventory (some of the lots having
been sold) is not $1,500, nor $4,000, but 4,000 X $150,000

or $3,000. 200,000


The principle here is not different from that applica-
ble to land although there are differences in detail. These
arise from the difference in the cost of maintenance, and
the certainty that in most cases even after liberal re-
newals the buildings will some time be worn out or an-
tiquated. To continue the original cost it must be certain


that all necessary repairs have been charged to expense.
This is more difficult because during a course of years it
is likely that additions and improvements, as well as nor-
mal repairs, will be made. Where an improvement, say
the introduction of an electric lighting plant, or an addi-
tion to the building has been made, it is difficult to deter-
mine how much of the money thus expended is to be con-
sidered as the cost of an additional amount of building
and how much is a mere repair or restoration of part of
the old building. The ever difficult task of distinguishing
between so-called " capital and revenue expenditures"
must be accomplished; and, after all that is done, allow-
ance must be made for the inevitable progress toward the
time when the building will no longer be serviceable for
the purposes of the company.


Valuation at cost price, with proper allowance for
depreciation is evidently the correct basis. But it should
be borne in mind that much of the equipment of the fac-
tory is of very temporary use, and a valuation near the
cost would be far from correct. Such articles as patterns,
in a short time may have practically no value. Lasts in
a shoe factory are a very large, item and accumulate with
changes in fashion at an appalling rate. Much care must
be exercised if the Balance Sheet is to escape being over-
loaded with what represents a real cost but is no longer
a real asset. Where the machinery used is not purchased
but made within the factory itself, as is very often the
case, the value is of course not the price which that
machinery would bring in the open market but the actual
manufacturing cost.

The inventory value of machinery may properly include
its cost of installation in the factory. (Whittaker v.


Amwell Nat. Bank. 52 N. J. Eq. 400. (1894)). This is
in harmony with the general principle that the inventory
has to do with the value to the going concern.


In the foregoing pages there has been only one objective
criterion of value, cost j>rice, and that is confessedly faulty
for it refers to an earlier and not to the present day val-
uation. But for investments that are quoted in a stock
exchange there is a definite objective determination of
to-day's value. The objection to making an independent
valuation of one's lands or houses is that there may be an
unconscious overvaluation, or that an intentional, and per-
haps fraudulent, overvaluation cannot easily be detected.
But where there is a definitely ascertainable market price,
known to the public and fixed by outside interests, the
objections just urged do not apply and it would seem that
it might be safe and justifiable to ignore altogether the
cost price, and alter the book value with every fluctuation
in the market price.

But if the securities are real investments, and not the
stock in trade of a banker the objection at once arises that
there can be no availing of the market price so long as the
securities are thus held. .For instance a National Bank
buys government bonds at par, the holding of a minimum
amount of such bonds being a prerequisite to the bank
doing any business. The bonds bought at par may rise
to 110 per cent., or conceivably fall below par, but it is
evidently impossible for the bank to realize this increase
in value, nor can it suffer a loss while it continues as a
going concern. To list the bonds at more or less than cost
price would, for the ordinary purposes of the bank, be
futile. It is true that if the bank went into liquidation
the variation would be realized, but to take account of


that possibility is counter to the generally accepted rule
that assets are to be inventoried at their value to the going

The bank may furthermore buy other bonds to serve
as the basis for additional circulation. These bonds, above

Online LibraryHenry Rand HatfieldModern accounting, its principles and some of its problems → online text (page 7 of 27)